Exchange Traded Funds Versus Individual Stocks – Which Is Better?

When Exchange Traded Funds ( ETFs) first were introduced they were compared very favourably to mutual funds. Much lower management fees, no deferred sales charges, better performance, more strategic tax efficiency were factors that investors needed to make the switch out of mutual funds..

Today there are so many types of ETFs that many investors really do not understand what they are invested in and how much risk these investments incorporate.

The basic principle of mutual funds and ETFs is risk reduction through diversification. The influx of sector and active ETFs both on the long and short side of the market has materially added a level of risk that was not the case for passive index ETFs of the overall major market indices.

New ETFs are being created every day that supposedly satisfy a client’s needs for equity participation in sectors of the market such as biotech, pot stocks, country specific emerging markets and cyber security. The list is endless and expanding continuously.

Despite the benefits of these trends, the traditional advantage of risk reduction from market diversification is being overshadowed by the sharp increase in unique risk. This risk is not being adequately conveyed to retail investors by the creators of ETFs who are principally driven by increasing their revenues at the expense of everything else.

Individual stock investing has unfairly received a bad rap for being too risky for many investors. However, as long as one is sufficiently diversified across all eleven equity sectors, combined with spreading the risk by investing in both value, growth, small, large cap and international companies, stock investing can produce superior returns and lower risk than many ETFs.

Furthermore, analyzing individual companies is much easier than attempting to do research on ETFs. Lack of transparency, limited disclosure of material factors and a short historical track record make ETF investing much riskier than a disciplined investment of individual stocks. Basic fundamental stock analysis is just not possible with ETFs. In most cases the security regulators only require the top ten holdings to be reported and this is simply not sufficient to accurately determine the level of risk assumed. Secondly, the holdings can change frequently and this makes the investment analysis even more difficult.

Alpha is defined as the excess returns created by investing in companies that beat their benchmark indices. This is the factor that the best money managers such as Peter Lynch, John Templeton and Warren Buffet use to create their superior long term performance. An investment in an ETF largely ignores or greatly diminishes the benefits of alpha, although there are some active ETFs with this goal in mind.

Frequently during my thirty years in this money management business, I have heard many retail client advisers belittle the benefits of stock picking. Clients deserve better. The decision to invest in an ETF that may hold a small investment in a superior stock will almost always water down the benefits of investing directly in that stock. Retail clients think they are getting superior stock picking from their adviser, but in many cases this is clearly not the case.

In conclusion, many retail investors are branching away from their investment advisers in order to improve their performance, lower their fees and lower their risk.

Investing in individual stocks is one investment approach we cannot afford to ignore.

Peter McMurtry, B.Com, CFA, Financial Writer

Monthly Strategies for Do It Yourself Investors

https://mcmurtryinvestmentreport.ca

peter@mcmurtryinvestmentreport.ca